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Sunday, 15 May 2011

The rationale of prohibition of Riba (usury/interest)

Riba, which means not only usury, but all forms of unearned income, has been strictly prohibited by Islam. Although the Qur’an did not specify any particular kind of riba, Muslim scholars have categorized it in two types: riba al-nasi’ah, and riba al-fadl. Riba al-nasi’ah refers to the interest on loans; its prohibition essentially implies that the fixing in advance of a positive return on a loan as a reward for waiting is not permitted in Islam. Riba al-fadl is the excess over and above the loan paid in kind.It lies in the payment of an addition by the debtor to the creditor in exchange of commodities of the same kind. The Shari’ah wishes to eliminate not merely the exploitation that is intrinsic in the institution of interest, but also that which is inherent in all forms of unjust exchange in business transactions.

Despite the fact that interest occupies a central position in modern economic system and that it became the very life blood of the existing financial institutions, Islam considers that the principle of charging interest is quite opposite of that of business in the spirit of sharing and cooperation and that lending on interest is not as a business in the real sense.

In legalizing trade and condemning interest, Islam considers that there are fundamental differences between the nature of profit resulting from interest charges and that earned by trade. In interest-based transactions, there may be no equitable division of profit between the buyer who makes a profit on the sale of good purchased, and the seller who derives a profit in consideration of the labour and time spent in procuring the goods. Moreover, there could be no end for an interest-based transaction, since there could always be interests of unpaid interests as long as the principle amount loaned is not fully returned. This could, in extreme cases, create un-repayable debt for generations

The rationale for the prohibition of interest the Islamic economic framework highlights how the risk-reward sharing would be more conductive to the realization of equity and the promotion of entrepreneurship. In fact, the interest-based banking system relies heavily on collateral and gives inadequate consideration to the strength of the project or the ultimate use of the financing. Even though collateral and cash flow are indispensable for ensuring repayment of loans, giving them undue weight result in a relative misestimating of the purpose for which borrowing takes place. Hence, that system tends to enforce the unequal distribution of capital by allocating financial resources mainly to the rich, who have the collateral and cash flow.

Islam considers even interest-based loans taken for investment in a productive activity as not equitable because in the profits that may accrue from it is not required to be known forehand and if there is a loss, the entrepreneur has to bear the entire loss in spite of all the risk and engagement he took, whereas the money lender, who did less sacrifice than the entrepreneur, gets an effortless profit determined by a positive rate. In Islam both risks and rewards should be shared by the different parties.

And since the unrestricted power of the creditor to make profit from interest has no regard to the financial ability of the debtor to repay indebtedness, middle-class consumers, as well as the developing countries, could be caught up in a never-ending debt-trap. And because the Riba system encourages living beyond one’s means for both individuals and governments, it results in an accentuation of macroeconomics, inflation and external imbalances in addition of squeezing the resources available for development. This leads some poorer countries to the over-exploitation of their earth’s resources and thus to the destruction of the ecological system.

Moreover, the high degree of interest rate volatility in the modern economies injects great uncertainty into the investment markets and makes it difficult for entrepreneurs to have a long-term investment vision and to make their decisions with confidence. This turbulence in the financial markets and the rise to fictitious assets tend to aggravate economic instability.

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